EDHEC Risk Institute: Majority of European Pension Funds Have a “Blinkered View of their Risks”

The FINANCIAL — In a new survey of 129 asset/liability management (ALM) specialists (pension funds, their advisers, regulators, and fund managers) representing assets under management of approximately €3 trillion, EDHEC Risk Institute finds, amongst other key conclusions, that the majority of respondents have a blinkered view of their risks: accounting risk (the volatility from the pension fund in the sponsor’s books) is managed by only 33% of respondents, and more than 50% ignore sponsor risk (the risk of a bankrupt sponsor leaving a pension fund with deficits).

In addition, pension funds generally do not assess the adequacy of their ALM, a failing that may lead to sub-optimal decisions’ being taken again and again.

According to Samuel Sender, Applied Research Manager at EDHEC Risk Institute and author of the “EDHEC Survey of the Asset and Liability Management Practices of European Pension Funds,” the first challenge for a pension fund involves meeting its liability by fully or partially hedging it away. The survey suggests that the liability-hedging portfolio (LHP) is modelled imprecisely at 45% of pension funds.

The second challenge for pension funds is to gain access to performance through optimal diversification within and between asset classes. Most respondents use market indices to define the investment benchmarks of investment funds, even though market indices are weighted by capitalisation and are known to be highly inefficient.

Additionally, even though they are the longest-term investors and are not subject to liquidity risk, pension funds invest relatively little in potentially illiquid assets and therefore do not benefit from the related risk premiums.

The last challenge for pension funds is to respect their minimum funding ratios by insuring risks away. To manage prudential constraints, 28% of respondents use risk-controlled investing (RCI) strategies, whereas 56% use economic/regulatory capital. Like RCI, economic capital relies on the measure of a risk budget and of a surplus. Economic capital, however, involves a discretionary, rather than rule-based, investment strategy, and possible delays.